The joyful art of picking blue chips like Warren Buffett

Warren Buffett, that paragon of lucrative investing, continues to swear by them, if his latest annual address to Berkshire Hathaway owners last week is any indication. Closer home, celebrated investors such as Rakesh Jhunjhunwala and Raamdeo Agrawal use them to pick consistent winners among Indian equities. Now, retail investors, particularly the new initiates to the equity cult, are seeking to master the art of harnessing concepts like return on equity (RoE) and return on capital employed (RoCE) to get rich.

And experts encourage them to study stocks like Nestle India, Hero MotoCorp, Castrol India, TTK Prestige, VIP Industries, Titan Industries to understand why certain equities generate consistently tremendous long-term returns. So what differentiates winners from others?

A key aspect that distinguishes the coveted stocks listed above is, over the last several years, they have all scored highly, in terms of both RoE and RoCE. Well, to be sure, RoE and RoCE are just two among the many important parameters that are used to identify quality companies in a particular industry or sector. But they are very popular and time-tested indeed.

RoE, also known as return on net worth, reveals the profit a company makes by deploying shareholders’ investments. The higher a company’s RoE relative to its industry peers the better it is, as it indicates that the company is utilising investors’ money and the surplus funds efficiently to improve its business operations. Companies that generate RoE in excess of the cost of equity are able to add value to their shareholders.

RoCE, on the other hand, indicates how well a company uses its capital (debt and equity) to generate returns for shareholders. Since the company may raise debt to increase RoE, it is, therefore, better to take RoE into account as well before investing in a particular stock.

Buffett has been using both these metrics together to figure out a company’s profitability and to separate high-debt stocks. Buffett considers RoE a better indicator of the company management’s performance than earnings per share (EPS) which takes into account only the current year earnings.

An analysis of RoE and RoCE over the last six years of the BSE-500 companies shows that consumer-oriented, services-related and two-wheeler stocks lead the pack. Colgate Palmolive (with an average RoE of 107% and RoCE of 131.87%), Nestle India (106.20% and 153.07%) and Hindustan Unilever (82.58% and 92.81%) are among the fast-moving consumer goods (FMCG) companies with high profitability ratios. Information technology (IT) companies like eClerx (with RoE of 104% and RoCE of 108.01%), Tech Mahindra (50.42% and 56.57%) and TCS (47.51% and 53.88%) also feature among the top companies.

One, however, shouldn’t go by higher RoE alone in selecting stocks as companies in different sectors have different RoE, depending on industry dynamics and structures.

“Undoubtedly, RoE is an important parameter, but it doesn’t make sense to compare stocks in different sectors on this parameter alone as the asset-light businesses usually have higher RoE because they don’t need too much investment and have high asset turnover, while the asset-intensive businesses have low-to-moderate RoE,” says Hemant Kanawala, head of equities, Kotak Mahindra Old Mutual Life Insurance.

Kanalwala believes that for an asset-heavy company, sustainable RoE of 15-25% is good enough even if some asset-light businesses have RoE in excess of 40-50%.

The higher price-to-earnings (P/E) multiples of FMCG and IT companies may be justified in a way by their higher RoE, as price or P/E commanded by a stock is positively related to earnings growth, its RoE and dividend payout.

Nilesh Shetty, associate fund manager, Quantum Asset Management Company, says that sectors (like oil, gas and commodities) where ownership of resources is a key differentiating factor, lend themselves least to RoE analysis. For, their current RoE would be highly influenced by where the industry is currently placed in the macro economic cycle.

So investors may be better off taking both RoE and RoCE, along with various other parameters, into consideration while selecting a stock.

To sum up, one should look for companies with consistently high RoE over a period of time. In his sixteenth Wealth Creation Study Report, Raamdeo Agrawal, joint managing director of Motilal Oswal Financial Services, says that an average RoE of 15% over a five-year period would suggest the stock is a potential blue chip.